Commercial mortgage-backed securities are securitizations of mortgage loans backed by commercial real estate.

Credit Risk

The loans that serve as CMBS collateral are commonly secured by commercial real estate such as apartment buildings, shopping malls, warehouse facilities, etc. Unlike most residential mortgage loans, these loans often do not provide recourse to the borrower or any form of guarantee. Lenders and investors look to the collateral, not the borrower, for ultimate repayment. Thus, analysis of the cash flows generated by the underlying properties as well as their value is critical. Credit analysis should be performed on a loan-by-loan basis because of the unique economic characteristics of each income-producing property in a pool.

There are two relevant measures:

• The debt-to-service coverage ratio (DSC) is net operating income / debt service. Loans with a debt service coverage ratio above 1.00 have a lower likelihood of default because they have a built-in excess cash flow buffer available; this would have to erode before the borrower would experience losses and consider defaulting.

• The loan-to-value ratio (LTV) is the ratio of loan amount to the value of the collateral property. A lower LTV loan is considered more creditworthy due to its better default protection.

Basic CMBS Structure

The major structural component of a CMBS deal is credit tranching. To have AAA rated tranches, there must be enough credit support from tranches that absorb any losses on the underlying collateral first. The tranches with less underlying credit support have lower credit ratings and investors are rewarded with commensurately higher yields. When delinquencies and defaults occur, cash flows otherwise due to the subordinated class are diverted to the senior classes to the extent required to meet scheduled principal and interest payments. Thus, subordination allows issuers to create highly-rated securities from collateral of various levels of quality.

Call Protection

Call protection comes in two forms: at the structure level and at the loan level. The creation of sequential-pay tranches is an example of call protection at the structure level.

Call protection at the loan level comes in several forms, including prepayment lockout (usually two - five years), and stiff prepayment penalties that serve as a deterrent to the borrowers. Treasury make-whole (yield maintenance) is a common form of prepayment penalty that requires the borrower to accompany any prepayment with a premium which, when reinvested by the loan owner in Treasuries for the remaining term of the loan (had it not been prepaid), would exactly recreate the lost yield on the prepaid loan. Fixed-percentage prepayment penalties are also common, and require the prepaying borrower to pay a premium equal to a set of percentages of the balance being prepaid.

An innovation in CMBS call protection is Treasury defeasance. This concept is similar to Treasury yield maintenance in that, instead of prepaying the loan, the borrower substitutes Treasury securities to replicate the cash flows of the mortgage.

Balloon Maturity Provisions

CMBS investors face two credit issues with respect to the CMBS mortgage pool: operational defaults (the risk that the property will not generate sufficient cash flow to make the monthly payments on the mortgage loan), and refinance risk (the risk that, at maturity, the property will lack sufficient value to be sold or refinanced in an amount sufficient to make the balloon payment.) Commercial mortgage loans usually balloon after 10 or 15 years and must be paid in full. Note that balloon loans have short maturities but longer amortizing terms, resulting in a lump sum payment due at maturity, which makes default highly likely if the borrower cannot refinance.